Whether you’re a seasoned ecommerce owner with years of experience or fairly new to the game, it will quickly become apparent just how competitive the entire landscape is, no matter what niche you operate in.
That’s why we encourage you to think about various different pricing tactics you can use to increase your profit margins and dominate your competition.
So in this article, we’re going to look at ecommerce price elasticity. Price elasticity is sometimes referred to as ‘price elasticity of demand’ and refers to how much of a demand there is for a specific product. It works in that when a product is superelastic, a small change in the price will ultimately alter the demand curve drastically. But conversely, for a product with little to no elasticity, when the price changes, the demand curve does not.
- Some use cases for price elasticity of demand
- How consumer quantity demand affects the price you’re able to charge for your products
- How to calculate your price elasticity of demand curve
- Why implementing this pricing strategy helps you better understand price changes and increases overall total revenue
What is ecommerce price elasticity of demand?
As we’ve established, price elasticity refers to the quantity demand for a particular product or item. In general, terms, when a product is a high price, fewer people will buy it, when it’s a lower price, more people will buy it.
But the crucial thing you need to understand is just how many people will buy when the price is lowered and just how few people will buy when the price increases. Price elasticity helps answer this question.
So the elasticity of a product concerns itself with the effect on the quantity purchased given particular incremental price changes.
It’s a quantitative (measured by the quantity of something rather than its quality) measure of the likelihood a consumer will buy a product at specific prices within the market.
The graph above shows the quantity demand curve. It’s also known as the arc of elasticity. Breaking it down, what we see here is as the price of a specific quantity of goods rises, consumers buy less of that good and instead find suitable substitute goods. This creates a knock-on effect where the quantity demand for that good falls.
But when we refer to demand elasticity, we’re concerned with understanding what degree the rising price results in falling quantity demand. If a 60% rise in price for a specific quantity of goods results in a 60% decrease in elastic demand, then the quantity demand elasticity is 1. However, if a 60% rise in price for a specific quantity of goods results in a 15% demand decrease then the demand elasticity is much lower. In these cases, you’ll notice a different shaped line (more horizontal)
The terminology surrounding demand can be confusing. “Quantity” or “quantity demanded” refers to the amount of the good or service, such as ears of corn, bushels of tomatoes, available hotel rooms or hours of labor. In everyday usage, this might be called the “demand,” but in economic theory, “demand” refers to the curve shown above, denoting the relationship between quantity demanded and price per unit.
Products with high levels of elasticity would have a large change in elastic demand through a slight change in price. Whereas products with little elasticity wouldn’t be affected by any price change, regardless of how insignificant.
As eCommerce owners, you understand just how difficult it can be to price your products. You don’t want to price too high and risk alienating yourself out of the market, and on the opposite side of the spectrum, you don’t want to price too low and lower your overall profit margins.
When you have a good understanding of price elasticity and how it relates to your products, you’ll be able to run better pricing tests with informed ideas about how best to optimize your own pricing.
How to calculate ecommerce price elasticity
Calculating price elasticity involves using an elastic demand formula (NOT GUESSWORK). To calculate the price elasticity of demand for a particular product follows this formula:
Price elasticity of demand = Percentage change in quantity demanded / percentage change in price.
But before we look into the elastic demand formula in more detail it’s important to know why we need to calculate it in the first place. Different products will have different degrees of elasticity, meaning they respond to change dramatically and in many cases, immediately. Having a good understanding of the market you’re trying to sell to will give you a better idea of why a product might sell well at one price point, but really poorly at a different price point.
In large though, some of the common reasons as to why a product might be elastic include:
- You’ve outpriced your market. If everyone else in your industry is charging $1 for a pen, and you come along and charge $8 for the same pen, you might find that sales decline. This is based on the outside elastic demand of your competitors.
- Your item isn’t essential to everyday life. Non-essential items are usually very elastic and very sensitive to any minor change in price. This is because the item isn’t a necessity and there will come a point where the price increases so much that the consumers refuse to buy.
- They can opt for a similar item instead. Think about buying a phone. If you have two phones with similar features, and suddenly one of the phones increases in price by $400, more people will opt for the alternative model.
Some products are very inelastic by nature, meaning when the price increases the elastic demand usually stays around the same point. A good example of this is people buying fuel for their cars. They know they need to run their car, so if the price of fuel increases, the demand usually stays around the same point.
So back to our elastic demand formula:
Price elasticity of demand = Percentage change in quantity demanded / percentage change in price.
We’ll use an example to help illustrate exactly how to use this formula in a real-life case.
Imagine, for a second, you own a hardware store.
You increase the price of your Power drill from $100 to $165. This is a price increase of 65%. What you might expect is that due to the increase in price, power drill sales will fall.
If we then calculate the quantity change we might see that the price increase resulted in sales falling from 100 units to just 30 units. The percentage of demand decrease is -70%.
We now have all the figures we need to input into our demand formula.
Percentage change in quantity (-.70) / percentage change in price (.65) = -1.08
So we know the price elasticity of the power drill is 1.08 (note: if you get a negative number, ignore the negative and just focus on the actual figure).
You’re not concerned with whether the number is negative or positive, what you’re concerned with is how close the number is to zero.
Numbers closer to zero = inelastic
Far from zero = elastic.
To give you an idea, analysts usually group the results into three categories.
0-1 when your ecommerce price elasticity falls in this range, the products are largely inelastic, whereby changes in prices results in small changes in the quantity demanded by consumers. Here, customers are less likely to choose a different product despite higher prices. Products in this category are usually defined as those which are explicitly necessary – for example an inhaler for an asthmatic person.
=1 Products with a price elasticity score of one are known as ‘unit elastic’ these products are ones where a percentage change in price is matched by an equal percentage change in quantity demand.
1+ When a product has a price elasticity of more than one, they are considered elastic. Incremental changes to price will have a direct impact on the quantity demanded by consumers. If your product falls into this category you can conclude it generally has a wide range of substitute goods. For example, chewing gum. If you suddenly increase your price by 140%, demand will fall because a consumer can buy any of the other chewing gum available on the market.
Using the midpoint method to calculate price elasticity
Another useful method for calculating the price elasticity of demand is to use the midpoint method. So far, we have understood that price elasticity refers to the responsiveness of the quantity demand to a change in price. We’ve also looked at the idea that price elasticity of demand is a percentage change in quantity demand of goods divided by the per cent change in price.
Let’s now look at the midpoint method which is where you’ll use the average quantity percentage change in both quantity and price.
The reason why the midpoint method works so well is that it uses the same average quantity elasticity between the two price points, regardless of whether or not the price increase or decreases because you’re using the same base for both demand formulas.
How to test ecommerce price elasticity with your own products
But just knowing how elastic your products are is useless unless you actually do something with the data you’ve collected.
You can use the data to help you make informed decisions about how to test prices for specific products and increase overall total revenue.
Products with high elasticity will have to have a larger number of tests to find the optimum price, whereas inelastic prices will have a much smaller price optimization window.
So when you have a good understanding of how elastic your products are, if you want to be able to change their prices without negatively affecting the demand, you might consider developing a stronger brand image.
If you can position your specific products as a necessity, when you increase prices, you know you won’t lose customers.
Ecommerce price elasticity final thoughts
Having a deep understanding of ecommerce price elasticity of demand is crucial for accurately predicting how much you should price your products for and how that price change will affect your total revenue. It’s a great tool to have in your arsenal if you’re hoping to increase your profit margins.
Implementing ecommerce price elasticity formulas into your ecommerce strategy allows you to be proactive, rather than reactive when it comes to effective price strategies.
When you understand both the market you’re trying to sell to and the elasticity of your product, you can get a clearer idea of how much you will be able to increase or decrease your products based on your own target audience. This understanding helps you increase total revenue and profits because you’re basing your pricing ideas on real data.
Consumers have a great deal more options at their disposal now. They spend more and more time searching for the best deal. As a result of that most products will fall into the elastic category. But the aim should be to build a brand around your product so that you can turn specific products inelastic.
By making your product stand out amongst a sea of competitors selling the exact same thing, you’ll be able to implement price changes without depleting the demand curve of people willing to buy it.
You can differentiate your products through features, offerings or support.
How elastic are your products? Go away and find out today